Futures market bets on supersized Fed rate hike with inflation running hot

The largest jump in inflation in 40 years has boosted the market odds of a supersized rate hike from the Federal Reserve to a near certainty.

The consumer price index, the market's preferred inflation metric, climbed 7.5% year over year in January, the fastest rate of annual growth since 1982, the U.S. Bureau of Labor Statistics reported Feb. 10. That hotter-than-expected inflation figure pushed market odds of a 50-basis-point hike to about 90% on Feb. 10, up from less than 8% just a month earlier, according to the CME FedWatch Tool, which measures investor sentiment in the Fed funds futures market.

The jump in inflation will compel the Fed to hike rates higher and faster than expected just a week ago and further tighten monetary conditions by reducing the central bank's nearly $9 trillion balance sheet as soon as this spring, economists said.

"The case for taking some steam out of the economy is getting stronger," said James Knightley, chief international economist with ING.

With inflation on the rise, the market now expects the Fed to move aggressively to tighten monetary policy, which will increase volatility in markets, said Matt Peron, director of research at Janus Henderson Investors.

"We are not surprised that there would be concern the Fed is moving too slow," Peron said.

Double hike

Soaring inflation will ramp up pressure on the rate-setting Federal Open Market Committee to approve a rate hike of 50 bps at its March meeting. This would be double the Fed's typical rate hike and its first increase of that size since 2000.

The majority of the market now expects a rate hike at every one of the FOMC's seven remaining meetings this year, according to the CME FedWatch Tool.

If, as expected, the Fed raises rates by at least 75 bps by June it would mark the fastest pivot on rates since 1994, Diane Swonk, chief economist with Grant Thornton, wrote in a Feb. 10 note.

The inflation data along with a stronger-than-expected jobs report for January "means the Fed has to abruptly hit the brakes which increases the risk of a misstep," Swonk wrote. Economists warn that the Fed's policy response to cool inflation, largely through rate hikes, will increase borrowing costs and brusquely slow economic growth, potentially driving the U.S. into another recession.

Rate hike expectations caused the Treasury yield curve to flatten further as front-end yields were driven higher. A flatter yield curve signals market concerns over economic growth.

The gap between the 10-year and 2-year Treasury bond yields fell to 42 bps on Feb. 10, down 44 bps in a month and the smallest the gap has been since August 2020.

Despite the flattening of the curve, inversion remains unlikely since persistent inflation pressures will limit any decline in the 10-year yield, said John Canavan, lead analyst with Oxford Economics. An inverted yield curve has preceded every U.S. recession over the past 50 years.

The 10-year yield settled at 2.03% Feb. 10, rising to above 2% for the first time since July 2019.